Hong Kong Mortgage Rate Setting - An Alternative Reference Rate?

Abstract

The Hong Kong Monetary Authority has completed a research study on the setting of mortgage rate by Authorized Institutions (AIs). The purpose of the project is to consider whether in an environment of intensive competition and, until recently, abundant liquidity in the banking system, the AIs have adequately taken into account their long term cost of funds in setting their mortgage rates. The study also compares the Best Lending Rate (BLR) with other alternative mortgage reference rates to consider which one(s) would enable AIs to better track their cost of funds in determining the interest rate for residential mortgage lending. The results are presented in this paper. The use of BLR as the reference rate for setting mortgage rates has been adopted by banks for many years. However, such a practice is not necessarily conducive to banks' management of interest rate risk, as the movement of BLR may deviate significantly from banks' cost of funds. In times when Hong Kong Interbank Offered Rates (HIBORs) and time deposit rates rise faster than BLR (typically during an interest rate hike cycle or when the risk premium of the Hong Kong dollar over the US dollar widens), the interest margin of banks' existing mortgage portfolios would be squeezed. This may lead to a material decline in banks' earnings and may impact on banking and financial stability. The market conditions during late January to April 2005 demonstrate vividly such risk. Drawing on overseas experience, several local interest rates, including the 3-month HIBOR, the effective deposit rate or EDR (a weighted average rate for demand, savings and time deposits), the composite rate (a weighted average rate of 3-month HIBOR and EDR), the Base Rate of the HKMA and the yield of the 3-year Exchange Fund Note (EFN), are examined in order to assess their relevance as alternative reference rates. The assessments are made by evaluating the appropriateness of each rate based on criteria of importance to consumers and factors relevant to banks. Together with other factors, the two key criteria for the assessment are (i) the stability of mortgage rates over time which is regarded as important by both borrowers and AIs, and (ii) conduciveness to interest rate risk management which is important for banking stability. A comparative analysis suggests that the composite rate is probably the best as it reflects closely the cost of funds of most AIs and is more stable than the 3-month HIBOR and the yield of EFN. The use of some "smoothing out" arrangements could further enhance the stability of the rate.

Keywords: Authorized Institutions, Best Lending Rate, Composite Interest Rate, Banking Stability

JEL Classification: G18, G21